Most individual and institutional investors are in essence outer directed. Either consciously or not they follow what others do and have a fundamental belief in “smart money.” For extended periods of time this philosophy has worked. Perhaps, it was my brother’s experience in the US Marine Corps Reconnaissance as the leading point for wartime patrols to avoid walking into an ambush. Or my experiences at the racetrack where betting favorites won only about one-third of the time. I look for instances where the “crowd” is wrong. Not to be just a contrarian, but looking at the profit opportunities when the generally unexpected occurs. Some of these opportunities are just plain random, others can be perceived ahead of time. Each of this week’s concerns has some evidence backing up the views as to future changes. Whether you agree or disagree let me know.
Is EPS our Golden Calf?
Throughout my investment career I have heard earnings, actually reported earnings per share, drives the market. In the 1960s I was told all one needed to know was the growth rate of earnings to determine the appropriate price/earnings ratio. Recently I heard a very well known and respected Portfolio Manager explain in a long cable news interview that “earnings drive the market.” The first thing he said about each of his five buy recommendations was their earnings per share. The analyst in me rebels at this kind of over simplification.
In a period where much of senior managements’ compensation is based on in order, EPS, sales, and market price - do you think that they attempt to show the best possible record? I don’t want to proclaim that they are totally manipulated or are the equivalent of “fake news” but it makes you wonder whether it is a true reflection of the value and future potential of the company. One of the first lessons from my Professor David Dodd, who wrote the five editions of Securities Analysis with Ben Graham, was to reconstruct the financial statements of the company under study. We laboriously went through each line in the income statement and balance sheet adjusting for removal of non-recurring elements and questioned the accounting techniques that produced each item. We were quickly taught that in various cases the results in the press release or Management’s letter did not give a totally accurate picture.
When professionals discuss the valuation of various Merger & Acquisition deals today, comparing them to others, the metric that they use is EBITDA. This stands for Earnings before Interest (net), Taxes (paid or accrued), Depreciation (based on what schedule), and Amortization (what were the write offs?). The drive here is to understand what was the operating earnings of the company. Net Interest is the result of the financial condition and policies of the company and might not be followed by a new owner. One of the simplest techniques that I learned at a trust bank was to put all the steel companies held in trust accounts on the same tax rate. This deprived some of the companies of their tax management skills, which were often transitory, but would be different under different ownership.
Depreciation charged is a function of the weighted ages of the plant and equipment with no adjustment for critical future expenditures. Amortization could be an orderly way to recognize the deteriorating value of intellectual property purchased and/or other write downs. To some degree I think all of these items plus debt service obligations are more important than reported earnings and so do the “M&A” troops.
Notice that a good portion of some companies “earnings improvement” comes from profit margin expansion. What this really means is that reported earnings are growing faster than sales. This is favorable when the company is increasingly earning more over its fixed cost base. However, it may mean that it is not spending enough on plant and equipment and/or research and development. These considerations are important in an increasingly competing world of relatively slow growth.
In history, when the ancient people felt that the Golden Calf did not answer their needs, not only did they destroy the statue, there was a period of turmoil and violence until new, and in some cases, better beliefs were established.
The Dangers of Buying the Next Dip
This past week there was an extremely sharp jump in the portion of the American Association of Individual Investors views on the market. In one week 41% are bullish, a gain of 12 percentage point from the week before with a concomitant decline in bearish beliefs and neutral holding about even. Both the Dow Jones Industrial Average and the S&P 500 went to new highs, not immediately echoed by the NASDAQ Composite. It is quite possible that the two senior averages need to catch up with the NASDAQ. The year to date performance shows the performance gaps, DJIA +12.68%, S&P500 +16.88% and NASDAQ + 22.96%.
Could this be the key missing element to a race to the top? While a number of highly respected market analysts expect a minor pull back, as there are a few price gaps that should be filled in before a major new top is reached. This could be accomplished by a 5 to10% correction. The Goldman Sachs* view is that there won’t be a dip as too many people are expecting it. (Remember the humility production function of the market.) This focus on sentiment over financials is a concern of Professor Robert Shiller as expressed in The Sunday New York Times when he refers to John Maynard Keynes’ belief that market participants were not making their own investment decisions, but were guessing what others were doing, in other words, trying to follow “smart money.”
*Held in the private financial services fund I manage
My concern is that this trading attitude may actually succeed. The risk is that the successful traders and later their acolytes will have faith that it is a repeatable result, and they are truly skilled. My concern is that when the next “Big One” occurs it will be quite different than managing through normal drops and even minor corrections. The difference is the size of the trading capital in the marketplace having to provide liquidity to non-price sensitive ETFs and margin-called players. There is little to no capital on the floor of the exchanges. Dealers have capital constraints and banks are limited by various regulations in a global marketplace connected in less than nano-seconds.
I don’t worry about trading losses, they come within the territory of investing. What I do worry about is the potential of future revulsions to investing and a generation that will decide “never again.” This will be tragic for themselves and their families. But also the rest of us taxpayers who are likely going to have to pick up some of their missing retirement capital.
More Evidence Indexing is Faulting
You have to excuse me for looking at the world with lenses that start with mutual funds which I have been following for more than fifty years.
Each week I look at the funds’ performance for varying time periods. For the week ending last Thursday I saw an interesting pattern evolving. My old firm, now part of Thomson Reuters, tracks close to 100 different fund peer groups. The largest equity group is the $ 1.2 Trillion S&P 500 Index funds. I compared its results for three periods and counted the number of peer groups that beat the large Index funds as shown below:
There were four fund types that beat the index in all three periods, 2 diversified and two sector fund types. The key point is more active managers are beating the Index. It is not because they switched from dumb pills to smart pills. It is due to greater variability of performance within the 500. Mathematically this splitting is called less correlation and greater dispersion. Within the Index there are some big winners and a few big losers which is meat to active managers, and in theory to long/short managers (hedge funds and the like).
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